Duration Mismatch Will Always Fail

I have written a number of pieces on fractional reserve banking and duration
mismatch. I have argued that the former is perfectly fine, both morally and
economically, but the latter is not fine. I have dissected the arguments made
against fractional reserve banking, and pointed out that it is nothing more
than a bank lending out some of the money it takes in deposits.

I have debunked the most common errors made by opponents of fractional reserve:

Banks print money

They lend more than they take in deposits

They inflate the money supply

Money is the same as credit

Fractional reserves banking is the same thing as central banking

It is the same thing as duration mismatch

Duration mismatch is when a bank (or anyone else) borrows short to lend long.
Unlike fractional reserve, duration mismatch is bad. It is fraud, it is unfair
to depositors (much less shareholders) and it is certain to collapse sooner
or later. This is not a matter for statistics and probability, i.e. risk. It
is a matter of causality, which is certain as I explain below.

This discussion is of paramount importance if we are to move to a monetary
system that actually works. Few serious observers believe that the current
worldwide regime of irredeemable paper money will endure much longer. Now is
the time when various schools of thought are competing to define what should
come next.

I have written
previously on why a 100% reserve system (so-called) does not work. Banks
are the market makers in loans, and loans are an exchange of wealth and income.
Without banks playing this vital role, the economy would collapse back to
its level the previous time that the government made it almost impossible
to lend (and certainly to make a market in lending). The medieval village
had an economy based on subsistence agriculture, with a few tradesmen such
as the blacksmith.

But I have not directly addressed the issue of why duration mismatch necessarily
must fail, leading to the collapse of the banks that engage in it. The purpose
of this paper is to present my case.

In our paper monetary system, the dollar is in a "closed loop". Dollars circulate
endlessly. Ownership of the money can change hands, but the money itself cannot
leave the banking system. Contrast with gold, where money is an "open loop".
Not only can people sell a bond to get gold coins, they can take those gold
coins out of the monetary system entirely, and stuff them under the mattress.
This is a necessary and critical mechanism--it is how the floor under the rate
of interest is set.

This bears directly on banks. In a paper system, they know that even if some
depositors withdraw the money, they do not withdraw it to remove it altogether
(except perhaps in dollar backwardation, at the end. See: http://keithweiner.posterous.com/dollar-backwardation).
They withdraw it to spend it. When someone withdraws money in order to spend
it, the seller of the goods who receives the money will deposit it again. From
the bank's perspective nothing has changed other than the name attached to
the deposit.

The assumption that if some depositors withdraw their money, they will be
replaced with others who deposit money may seem to make sense. But this is
only in the current context of irredeemable paper money. It is most emphatically
not true under gold!

There are so many ills in our present paper system, that a forensic exploration
would require a very long book (at least) to dissect it. It is easier and simpler
to look at how things work in a free market under gold and without a central
bank.

Let's say that Joe has 17 ounces of gold that he will need in probably around
a month. He deposits the gold on demand at a bank, and the bank promptly buys
a 30-year mortgage bond with the money. They assume that there are other depositors
who will come in with new deposits when Joe withdraws his gold, such as Mary.
Mary has 12 ounces of gold that she will need for her daughter's wedding next
week, but she deposits the gold today. And Bill has 5 ounces of gold that he
must set aside to pay his doctor for life-saving surgery. He will need to withdraw
it as soon as the doctor can schedule the operation.

In this instance, the bank finds that their scheme seems to have worked. The
wedding hall and the doctor both deposit their new gold into the bank. "It's
not a problem until it's a problem," they tell themselves. And they pocket
the difference between the rate they must pay demand depositors (near zero)
and the yield on a 30-year bond (for example, 5%).

So the bank repeats this trick many times over. They come to think they can
get away with it forever. Until one day, it blows up. There is a net flow of
gold out of the bank; withdrawals exceed deposits. The bank goes to the market
to sell the mortgage bond. But there is no bid in the mortgage market (recall
that if you need to sell, you must take the bid). This is not because of the
borrower's declining credit quality, but because the other banks are in the
same position. Blood is in the water. The other potential bond buyers smell
it, and they see no rush to buy while bond prices are falling.

The banks, desperate to stay liquid (not to mention solvent!) sell bonds to
raise cash (gold) to meet the obligations to their depositors. But the weakest
banks fail. Shareholders are wiped out. Holders of that bank's bonds are wiped
out. With these cushions that protect depositors gone, depositors now begin
to take losses. A bank run feeds on itself. Even if other banks have no exposure
to the failing bank, there is panic in the markets (impacting the value of
the other banks' portfolios) and depositors are withdrawing gold now, and asking
questions later.

What happened to start the process of the bank run? In reality, the depositors
all knew for how long they could do without their money. But the bank presumed
that it could lend it for far longer, and get away with it. The bank did not
know, and did not want to know, how long the depositors were willing to forego
the use of their money before demanding it be returned. Reality (and the depositors)
took a while, but they got their revenge. Today, it is fashionable to call
this a "black swan event." But if that term is to have any meaning, it can't
mean the inevitable effect caused by acting under delusions.

Without addressing the moral and the legal aspects of this, in a monetary
system the bank has a job: to be the market maker in lending. Its job is not
to presume to say when the individual depositors would need their money, and
lend it out according to the bank's judgment rather than the depositors'. Presumption
of this sort will always result in losses, if not immediately. The bank is
issuing counterfeit credit (http://keithweiner.posterous.com/inflation-an-expansion-of-counterfeit-credit).
In this case, the saver is not willing (or even knowing) to lend for the long
duration that the bank offers to the borrower.

Do depositors need a reason to withdraw at any time gold they deposited "on
demand"? From the bank's perspective, the answer is "no" and the problem is
simple.

From the perspective of the economist, what happened is more complex. People
do not withdraw their gold from the banking system for no reason. The banking
system offers compelling reasons to deposit gold, including safety, ease of
making payments, and typically, interest.

Perhaps depositors fear that a bank has become dangerously illiquid, or they
don't like the low interest rate, or they see opportunities offshore or in
the bill market. For whatever reason, depositors are exercising their right
and what they expressly indicated to the bank: "this money is to be withdrawn
on demand at any time."

The problem is that the capital structure, once erected, is not flexible.
The money went into durable consumer goods such as houses, or it went into
partially building higher-order factors of production. Imagine if a company
today began to build a giant plant to desalinate the Atlantic Ocean. It begins
borrowing every penny it can get its hands on, and it spends each cash infusion
on part of this enormous project. It would obviously run out of money long
before the plant was complete. Then, when it could no longer continue, the
partially-completed plant would either be disassembled and some of the materials
liquidated at auction, or it would sit there and begin to rot. Either way,
it would finally be revealed for the malinvestment that it was all along.

By taking demand deposits and buying long bonds, the banks distort the cost
of money. They send a false signal to entrepreneurs that higher-order projects
are viable, while in reality they are not. The capital is not really there
to complete the project, though it is temporarily there to begin it.

Capital is not fungible; one cannot repurpose a partially completed desalination
plant that isn't needed into a car manufacturing plant that is. The bond on
the plant cannot be repaid. The plant construction project was aborted prior
to the plant producing anything of value. The bond will be defaulted. Real
wealth was destroyed, and this is experienced by those who malinvested their
gold as total losses.

Note that this is not a matter of probability. Non-viable ventures will default,
as unsupported buildings will collapse.

People do not behave as particles of an "ideal" gas, as studied by undergraduate
students in physics. They act with purpose, and they try to protect themselves
from losses by selling securities as soon as they understand the truth. Men
are unlike a container full of N2 molecules, wherein the motion of some to
the left forces others to the right. With men, as some try to sell out of a
failing bond, others try to sell out also. And they are driven by the same
essential cause. The project is non-viable; it is malinvestment. They want
to cut their losses.

Unfortunately, someone must take the losses as real capital is consumed and
destroyed. A bust of credit contraction, business contraction, layoffs, and
losses inevitably follows the false boom. People who are employed in wealth-destroying
enterprises must be laid off and the enterprises shut down.

Busts inflict real pain on people, and this is tragic as there is no need
for busts. They are not intrinsic to free markets. They are caused by government's
attempts at central planning, and also by duration mismatch.

Keith Weiner is CEO of Monetary Metals, a precious metals fund company in
Scottsdale, Arizona. He is a leading authority in the areas of gold, money,
and credit and has made important contributions to the development of trading
techniques founded upon the analysis of bid-ask spreads. He is founder of DiamondWare,
a software company sold to Nortel in 2008, and he currently serves as president
of the Gold Standard Institute USA.

Weiner attended university at Rensselaer Polytechnic Institute, and earned
his PhD at the New Austrian School of Economics. He blogs about gold and the
dollar, and his articles appear on Zero Hedge, Kitco, and other leading sites.
As a leading authority and advocate for rational monetary policy, he has appeared
on financial television, The Peter Schiff Show and as a speaker at FreedomFest.
He lives with his wife near Phoenix, Arizona.